Chapter 6. Revaluations and impairment testing of non-current assets. Objectives of this lecture. Objectives (cont.)

(1)

PPTs to accompany Deegan, Australian Financial Accounting 7e

6-1

Chapter 6

Revaluations and

impairment testing of

non-current assets

6-2

Objectives of this lecture

• Understand the meaning of fair value

• Understand how and when to revalue an item of

property, plant and equipment in accordance

with AASB 116

• Understand how and when to revalue an

intangible asset in accordance with AASB 138

• Understand the difference in accounting

treatments for upward revaluations to ‘fair value’,

as opposed to write-downs to ‘recoverable

amount’

• Understand what an ‘impairment loss’ is and

know how to account for one

Objectives (cont.)

• Understand how to account for revaluations that

act to reverse previous revaluation increments

and decrements

• Understand how to account for accumulated

depreciation when a non-current depreciable

asset is revalued

• Understand that, subsequent to revaluation, new

depreciation charges will be based on the

revalued amount of the non-current asset

• Know how the profit is determined on disposal of

(2)

6-4

Objectives (cont.)

• Understand how asset revaluations can affect an

organisation’s profits owing to changes in

depreciation expenses and in final profits or

losses on the sale of the revalued asset

• Be able to explain possible motivations driving

an organisation to elect to revalue, or not to

revalue, its non-current assets to fair value

• Know the disclosure requirements pertaining to

asset revaluations

6-5

Relevant accounting standards

There are three standards of particular relevance

1. AASB 116 Property, Plant and Equipment

Requirements for revaluations, depreciation and

determining acquisition cost of property, plant and

equipment

2. AASB 138 Intangible Assets

Revaluation of intangible assets and other issues

3. AASB 136 Impairment of Assets

When to recognise an ‘impairment loss’

Introduction to revaluations

• Historical cost has been criticised for bearing no

relation to current asset values

• In Australia, entities may revalue many

non-current assets

– However, AASB 138 specifically excludes the

revaluation of some intangible assets

• Asset revaluations—what are they?

– Recognising a reassessment of the carrying amount of

a non-current asset to fair value as at a particular

date

(3)

6-7

Introduction to impairment losses

• If a non-current asset’s carrying amount

exceeds its recoverable amount it must be

written down to its recoverable amount (AASB

136)

– The write-down is called an impairment loss

(again, not to be confused with a revaluation)

– Carrying amount: cost of asset (or revalued

amount) less accumulated depreciation and

accumulated impairment losses

– Recoverable amount: higher of an asset’s fair

value less costs of disposal, and value in use

6-8

Introduction to impairment losses

(cont.)

– Fair value, less costs of disposal (or net

selling price): amount obtained from the sale of

an asset in an arm’s length transaction between

knowledgeable, willing parties less the costs of

disposal

– Value in use: present value of the future cash

flows expected to be derived from an asset

Impairment losses

• Impairment losses can be reversed in subsequent

periods (unless a particular accounting standard

prohibits it—as is the case with intangible assets)

• Worked Example 6.1 (p. 205) provides an example of a

reversal of an impairment loss

• Impairment losses will at times be determined by

reference to a ‘cash-generating unit’ rather than to a

specific asset.

• AASB 136 defines a cash-generating unit as ‘the

smallest identifiable group of assets that generates

cash inflows that are largely independent of the cash

inflows from other assets or groups of assets’

• See Worked Example 6.4 (p. 208)—Accounting for an

impairment loss by reference to a cash-generating unit

(4)

6-10

Worked Example 6.4—Accounting for an impairment

loss by reference to a cash-generating unit

Ulladulla Ltd has a printing process comprising four

separate but highly interdependent assets.

The printing machinery has a combined carrying value

of $1 000 000, made up as follows:

Asset 1

$100 000

Asset 2

$200 000

Asset 3

$300 000

Asset 4

$400 000

$1 000 000

• It was determined that the value in use of the

cash-generating unit, which is calculated at its present value,

amounted to $800 000

6-11

Worked Example 6.4—Accounting for an impairment

loss by reference to a cash-generating unit (cont.)

• The current fair value less costs of disposal of the

entire unit is $750 000

• The total impairment loss will therefore be equal to

$1 000 000 less the greater of the value in use and fair

value less costs to sell

• This gives us a total impairment loss of $200 000.

The impairment loss would be apportioned across the

four assets by using their respective carrying values

as the basis for the allocation.

For example, the allocation of the impairment loss to

Asset 4 would be 400 000 divided by 1 000 000

multiplied by 200 000. This would equal $80 000

Worked Example 6.4—Accounting for an impairment

loss by reference to a cash-generating unit (cont.)

Hence the accounting entry to record the impairment

loss on the cash-generating unit would be:

Dr Impairment

loss 200

000 Cr

Accum. impairment losses—Asset 1

20 000

Cr

Accum. impairment losses—Asset 2

40 000

Cr

Accum. impairment losses—Asset 3

60 000

(5)

6-13

Measuring property, plant and equipment at

cost or fair value—the choice

• AASB 116 requires each class of property, plant and

equipment to be measured at either cost or fair value

– Examples of classes are land and buildings,

machinery and motor vehicles

• Some classes might be measured at cost and others

at fair value

• With a mix of measurement methods, is the total

balance of non-current assets meaningful?

• Entities may switch from fair value to cost for

justifiable reasons and provided adequate

disclosures are made (AASB 116)

6-14

Measuring property, plant and equipment at

cost or fair value (cont.)

• Where an entity changes from cost (that is, they

have been using the ‘cost model’) to fair value (that

is, they have decided to use the ‘revaluation model’)

for a class of non-current assets and there was a

previous impairment loss (AASB 116):

– any increase in an asset’s carrying amount is first

recognised as income; and

– any excess above the amount if no impairment

loss was recognised is transferred to a

revaluation surplus account

Measuring property, plant and equipment at

cost or fair value (cont.)

• If a class of non-current assets is measured at cost,

AASB 136 is to be applied:

– if an asset’s carrying amount is greater than its

recoverable amount, an ‘impairment loss’ must be

recognised

(6)

6-16

The use of fair values

• Any revaluation of non-current assets must be to

fair value (AASB 116)

• Fair value is defined in the accounting standard and

in accordance with AASB 13 Fair Value

Measurement (issued in September 2011) as:

– the price that would be received to sell an asset or paid to

transfer a liability in an orderly transaction between market

participants at the measurement date.

• This definition of fair value is the same as that of fair

value used in other accounting standards.

• Hence, under AASB 116 a specific valuation method

has been stipulated, this being fair

• Fair value is determined on the assumption that

the entity is a going concern

6-17

The use of fair values (cont.)

• The required disclosures regarding asset

revaluations (AASB 116) are:

– effective date of revaluation

– whether an independent valuer was involved

– methods and significant assumptions applied

– extent to which fair values were determined, with

reference to observable prices in active markets or recent

market transactions

– for each revalued class, the carrying amount if the cost

model was used

– the revaluation surplus, indicating the change for the

period and any restrictions on distribution of the balance to

shareholders

The use of fair values (cont.)

• Revaluations must be made with sufficient

regularity so the carrying amount of each asset

in the class does not differ materially from its fair

value (AASB 116)

• If values change regularly and changes are

material, revaluations might be necessary each

reporting period

(7)

6-19

Revaluation increments

• General procedure (AASB 116)

Debit

Asset

Credit Revaluation

surplus

• The revaluation surplus is part of shareholders’

funds (owners’ equity)

6-20

Treatment of balances of accumulated

depreciation upon revaluation

• If a revalued asset is a depreciable asset, any balance of

accumulated depreciation is credited to the asset account prior

to revaluation (AASB 116)

• Journal entry (net-amount method)

Dr Accumulated depreciation—machine

Cr

Machine

Dr Machine

Cr

Revaluation surplus

• Subsequent depreciation is to be based on the revalued

amount of the asset

Worked Example 6.5—Revaluation of a depreciable

asset using the net-amount method

As at 1 July 2014, Farrelly Ltd has an item of

machinery that originally cost $40 000 and has

accumulated depreciation of $15 000.

Its remaining life is assessed to be five years, after

which time it will have no residual value.

Farrelly decided on 1 July 2014 that the item should

be revalued to its fair value, which was assessed as

$45 000.

(8)

6-22

Worked Example 6.5—Revaluation of a depreciable

asset using the net-amount method (cont.)

The total revaluation increment will represent the difference

between the carrying amount and the fair value. In this case it

would be:

$45 000 – ($40 000 – $15 000) = $20 000

The journal entries on 1 July 2014 would be:

Dr Accumulated depreciation—machinery 15 000

Cr Machinery

15 000

Dr Machinery

20 000

Cr Revaluation surplus

20 000

6-23

Illustration 2—Revaluation increment

• A building with a cost of $400 000 and accumulated

depreciation of $190 000 is revalued to its fair value of

$350 000

• What are the journal entries?

Dr Accumulated depreciation

190 000

Cr Building

190 000

Dr Building

140 000

Cr Revaluation surplus

140 000

Treatment of balances of accumulated

depreciation upon revaluation (cont.)

• Alternative method (AASB 116)

– Accumulated depreciation may be restated

proportionately with the change in gross carrying

amount of the asset, so the carrying amount after

revaluation equals the revalued amount

– This is referred to as the gross method

• Journal entry

Debit Asset

(9)

6-25

Revaluation decrements

• In line with the concept of conservatism, revaluation

decrements are recognised as an expense within profit or

loss in the statement of comprehensive income

• Contrast this with a revaluation increment wherein the

increase in the revaluation surplus is included in ‘other

comprehensive income’

• Journal entry (AASB 116)

Dr

Accumulated depreciation

Cr

Asset

Dr

Loss on revaluation of asset

Cr Asset

Refer to Worked Example 6.7 (p. 213)

—A revaluation decrement

6-26

Illustration—Revaluation decrement

Refer to the previous example, except this time the fair

value of the building (acquired for $400 000 and having

accumulated depreciation of $190 000) is $150 000 rather

than $350 000

What are the journal entries?

Dr

Accumulated depreciation

190 000

Cr

Building

190 000

Dr

Loss on revaluation of building 60 000

Cr

Building

60 000

Reversal of revaluation decrements and

increments

• For an asset class, reversals of previous revaluations

should be recorded by the reverse of the initial

revaluation entries

• If a revaluation decrement reverses a previous increment

for the same asset, then the entries are:

Dr

Accumulated depreciation

Cr

Asset

Dr

Revaluation surplus

Dr

Loss on revaluation (the excess, if any)

Cr

Asset

(10)

6-28

Example of a reversal of a previous revaluation

increment (Worked Example 6.8, p. 214)

• PK Ltd acquires a block of land on 1 January 2013 for $200 000 in

cash

• Due to increased housing demand in the area, the land has a

market value of $290 000 on 1 January 2014

• However, the market value falls to $140 000 on 30 June 2016

1 January 2013

Dr Land

200

000 Cr Cash

200

000 1 January 2014

Dr Land

90

000 Cr Revaluation

surplus

90

000 30 June 2016

Dr Revaluation

surplus

90

000 Dr

Loss on revaluation of land

60 000

Cr Land

150

000 6-29

Reversal of revaluation decrements and

increments (cont.)

• If a revaluation increment reverses a previous

decrement for the same asset then we

recognise a gain, which is included within profit

or loss, to the extent it reverses the previous

revaluation decrement.

• The general form of the journal entry would be:

Dr Asset

Cr

Gain on revaluation

Cr Revaluation surplus (the excess if any)

Example of a reversal of a previous revaluation decrement

Land was acquired for $200 000 on 1 July 2012. On 30 June 2013 it has

a fair value of $150 000. On 30 June 2015, due to increased population,

the land is considered to have a fair value of $270 000

1 July 2012

Dr Land

200

000 Cr Cash

200

000 30 June 2013

Dr

Loss on revaluation of land 50 000

Cr Land

50

000 (loss included within profit or loss)

30 June 2015

Dr Land

120

000

(11)

6-31

Accounting for the gain or loss on

disposal of a revalued non-current asset

• Gain or loss from derecognition of an item of

property, plant and equipment is to be calculated

as the difference between (AASB 116):

– net disposal proceeds (if any), and

– the asset’s carrying amount

• Derecognition is:

– the point in time when an asset is removed from the

statement of financial position (balance sheet)

– when an asset is sold, or

– when no future economic benefits are expected from

an asset’s use or disposal

6-32

Accounting for profit on disposal of a

revalued non-current asset

• When an asset is sold, any resulting balance in the

revaluation surplus (AASB 116):

– may be transferred directly to retained earnings

– cannot be transferred to the profit or loss

• If a non-current asset is revalued upwards, any gain

on sale will be less than the gain if the asset had not

previously been revalued

• Refer to Worked Examples 6.9, 6.10 and 6.11 on

pages 216–218

Consideration of present values

• Recoverable amount is the

higher of an asset’s fair value

less costs of disposal, and value in use (AASB 136)

• Value in use (AASB 136) is:

– the present value of the future cash flows expected from an

asset

• Estimating value in use (AASB 136) involves:

– estimating future cash inflows and outflows from the

continued use and subsequent disposal of the asset; and

– applying the appropriate discount rate to future cash flows

• Discounting future cash flows will decrease the calculated

recoverable amount

(12)

6-34

Can we offset revaluation increments and

decrements within a class of assets?

• Increments and decrements may be offset only

to the extent that they relate to a particular asset

(AASB 116)

- Therefore, if, say, one item of land increased in fair

value by $10 million and another item of land

decreased in fair value by $1 million (and assuming no

prior revaluations), then a loss of $1 million would be

recognised in profit or loss for the period (and the $10

million would be shown as part of ‘other

comprehensive income’)

Do we think this is ‘sensible’?

6-35

Economic consequences of asset

revaluations

• If contracts in place are tied to reported profits

(debt or management compensation),

management might have an incentive not to

revalue

• However, if assets are increased, a revaluation

might loosen constraints such as debt-to-assets

restrictions

• Firms subject to political scrutiny might be more

likely to undertake upwards revaluation resulting

in a reduction in profits

• As the perceived competence of independent

valuers increases, audit time might be reduced

Disclosure requirements

• AASB 116 includes various disclosure

requirements relating to the revaluation of

non-current assets

• These were previously discussed under the

heading ‘The use of fair values’

(13)

6-37

Summary

• This lecture considered the revaluation of

non-current assets, with the emphasis on property,

plant and equipment

• If the recoverable amount is below the carrying

amount, an impairment loss should be recorded

• For upwards revaluations:

– assets are to be revalued to fair value

– any increase is to be transferred to a revaluation

surplus, unless it is a reversal

• For downwards revaluations:

– any decrease is to be treated as an expense, unless it

is a reversal

6-38

Summary (cont.)

• When a revaluation is undertaken:

– any existing accumulated depreciation should be

credited against the non-current asset (if the net

method is used—which is the common approach), and

– the non-current asset should be increased by the

amount of the revaluation

• Where a revalued asset is sold, the gain or loss

is the difference between the carrying amount

and the net disposal proceeds of the asset

• The lecture also discusses how revaluations can